dear oilfield: time to delivery returns

NOVOTEL LONDON WEST • LONDON, UNITED KINGDOM • 2-4 APRIL 2019

Dear Oilfield: Time To Delivery Returns

James C. West

Evercore ISI

© M C E D e e p w a t e r D e v e l o p m e n t a n d G u l f Q u e s t L L C 2

The Status Quo Isn’t Working

• Oilfield Services industry returns have collapsed as the commercialization of shale changed the energy value chain

• Rather than seek to preserve value, the industry instead:

o Chased market share and bundled services to protect utilization

o Allowed pricing concessions which were used to primarily unlock the steep ramp in service intensity and well complexity

o Generated technological advances to improve operator productivity, but also cannibalized opportunities for additional services spending while much of the value was captured by the E&P companies

o Built for peak levels of demand while shale development is driving shorter cycles with rapidly changing levels of demand

• Investor sponsorship has waned as ROIC appears to be in secular decline causing investors to push valuation multiples lower

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Barely earning the cost of capitalLast peak was 10 years ago

4-Quarter Trailing ROIC for EVRISI_OFS Sector


Lower Returns = Lower Valuations

• Oilfield Service capital discipline was abysmal during 2009-2018 as evidenced by the surge in capital spending per unit of capital employed

• This led to lower returns and valuation and poor performance in the equity market. Reinvestment risk was clearly underestimated by every Oilfield Service company during the past decade

• The solution is to first identify and then employ value-based strategies that are aligned with shareholders while generating economic moats that generate higher returns and free cash flows. It is a simple solution but not easy to execute

• Generalist investors have eschewed the easily-replicable business models and highly-cyclical nature of our sector which drives a vicious cycle where market caps are driven lower which further reduces the overall investibility

OFS Sector ROIC vs. Price/Book Multiples

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Valuations Neared A 20-Year Bottom Recently

• As of the end of December 2018, the OFS sector was trading near the lowest Price/Book multiple in the past 20 years

o Large Cap Capital Equipment, SMID Cap Niche Technology, Offshore Drillers and Onshore Drillers were cheap

o On a 2-Year EBITDA Consensus basis the stocks are still above the Financial Crisis lows

o If one invested $1 in OSX 20 years ago, it would be worth ~$2.10 as of year-end 2018, versus $2.30 for the S&P, $4.75/bbl for WTI and $6.35/bbl for Brent

• In order for OFS to provide adequate returns above the cost of capital, the group has to reclaim its position in the value chain through better pricing, higher returns, and consolidation

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Historical Price Performance (Indexed) Historical Price-to-Book Values


Relative Returns Drives Investor Engagement…

• In the last 20 years, the oilfield services sector has earned more than its cost of capital only during the 2004-2008 time period. ROIC went negative this past downcycle and three years into the recovery returns are barely positive

• OFS stocks have disconnected from the movement in oil prices. This reflects the economic rent paid at the expense of OFS firms as E&Ps exacted operating efficiencies and pricing concessions at the same time, driving a collapse in ROIC

• S&P Oilfield Services declined from 1.6% to 0.5% of S&P 500 during 2008-2018 as returns and valuation declined. Market caps have shrunk across the space, with much of our coverage universe smaller than they were 10 years ago

• FCF yields in OFS have averaged nearly 3% over the past decade versus ~6% for the S&P 500 and were higher for only four quarters. Aside from market cap limitations, the uncompetitive yields provides investors with another reason to avoid the sector

TTM FCF Yields for OFS and S&P 500


And In Turn, Investors Left In Droves…

• Oilfield Services rose from 0.5% of S&P 500 in 2000 to 1.6% in 2008 and has declined since as the industry moved away from astute capital allocation and shareholder-friendly policies

• Additionally, company strategies chased market share growth while increasing PP&E for peak-level demand, despite the cyclical nature of the oil patch that generally calls for mid-cycle capacity (similar to industrials)

• The declining returns generated over the past decade has prompted a broader group of investors to seek out other sectors with competitive economics and relative valuations. It’s time for the OFS industry to pursue a new path

Sector Weightings and Returns on Equity (ROE)

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Difficult Competitive Structure

• Adverse competitive forces undermine industry profitability in Oilfield Services. Competition is rising in major product areas leading to a convergence of competitive advantages and reversion to the mean on returns since 2008. U.S. shale has become especially commoditized

• Declining dispersion of returns in Oil Service (top) indicates declining breadth of attractive investment opportunities and that capital investment should be more focused and measured. The bottom chart indicates that a major value transfer is underway between Oilfield Service companies and E&P entities

• Rather than seek to preserve value, companies sought greater market positioning despite the structural predicament. Intense competitive conditions exist in almost every major oilfield service product line (See next page)

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Declining Industry Concentration

• The Oilfield Service concentration index (Herfindahl-Hirschman or HHI) declined significantly (16%) on a revenue weighted basis during the past decade or so too (top chart)

• Sector revenues were stagnant but companies sought to sustain market share thru assertive pricing strategies and/or bundling of products

• Profitability declined significantly with EBITDA and EBIT margins falling by a whopping 21% and 40% during the period

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Oil Services: High Fragmentation

• The Oilfield Service sector has low returns on capital, stagnant revenue growth and is highly fragmented. Standardization, saturation in key markets, declining product differentiation and rising buyer sophistication render assertive pricing strategies across the sector

• While LWD and Inspection and Coatings represent attractive segments; the other 33 Oil Service sectors are highly fragmented. Low barriers to entry, the absence of economies of scale and experience curves, unfavorably affect returns and profitability in these businesses

Inspection & Coating

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Declining Concentration = Rising Fragmentation

• More competition leads to convergence of competitive advantage and declining returns on capital with competitive moats eroding over time

• We looked at concentration / fragmentation in a number of product lines and found that +90% of the 35 OFS segments we analyzed are 1) below moderate concentration (i.e., fragmented) and 2) concentration declined every year of the past decade

• The chart below, from left to right, shows which product lines have experienced the most fragmentation over the last decade

• It’s time to reduce investment, cut costs, divest or consolidate in order to enhance returns on capital

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Herfindahl-Hirschman Index (HHI) Scores for 35 Product Lines in OFS


Shale Commercialization = OFS Commoditization

• The OFS industry became overcapitalized as barriers to entry were low which allowed significant capital to enter the space, typically at sector peaks. History has tended to repeat itself

• This was the case in the commoditized onshore shale business which hurt the returns companies historically generated

o There is a wide range of results from industry participants, ex. 2018 annualized EBITDA per frac spread ranged from $10-20M

o Further, shorter cycle shale development results in quick changes in demand, making strategic planning challenging

• International and offshore spending declined during the last downturn, which historically have been more consolidated, higher barrier to entry and with greater technology applications. To grow market share in shale, capital has poured in

o Recent examples include pressure pumping companies delivering new capacity into an oversupplied market

o In addition, bundling of services to pull through more meaningful service lines resulted in a “loss leader” mentality

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Pressure Pumping Becomes Largest Subsector in 2017

Preceding Stagnant Returns

Median Annualized EBITDA Per Spread ($M)

Masks Wide Dispersion From Industry Players


Following The OFS Herd Is Not Advised

• While absolute performance was poor for Oilfield Service stocks, relative performance was too. The chart indicates that S&P Oilfield Services underperformed S&P 500 significantly during the past decade

• Benefits from higher oil and gas prices and rising demand for oilfield services were offset by value destruction from corporate strategies. Bets against Oilfield Service management teams were lucrative with S&P Oil Services underperforming S&P 500 by 8 PP annually during the past decade

• While Oilfield Service boards incentivize economic value creation with some pay metrics, CEO’s reach target pay with ROCE below 5% and negative EVA i.e. value destruction

• Higher oil prices are viewed as negative for many Oilfield Service companies as favorable demand for services but poor capital management has led to lower full-cycle returns

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Setting The Tone From The Top

• Companies need to be more pro-active in shaping the path forward rather than waiting for market conditions to improve

• Certain firms have cut capex 15-30% YoY for 2019 and investors have rewarded them accordingly in the stock market

• The industry needs the market leaders to set the tone by doing the following:

# Action

1 Use market power to push pricing higher, even at the expense of market share

2 Focus on building capacity to meet mid-cycle demand levels and not peak demand

3 Develop new commercial models to capture value from new technology

4 Divest non-core assets to drive better returns - do not be afraid to shrink

5 Reduce capex – invest only in differentiated services and products

6 Improve internal efficiencies – exit non-core countries, improve asset turns,

aggressively manage working capital

7 Cut R&D if value added technology not being paid for by customers

© M C E D e e p w a t e r D e v e l o p m e n t a n d G u l f Q u e s t L L C

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It’s Time To Exit The “Shale Dot Com” Phase Of Growth

• A plethora of capital was invested in the past decade to chase revenue and market share growth

• As growth matures in shale development, we believe companies should focus their investment towards competitively advantaged investment opportunities and reduce / exit service lines where they lack scale

• Too often a service line that was historically part of the business but is not really core to operations today is held onto for lack of a great exit strategy

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It’s Time To Lower Capital Investment Levels

• Our sector spent many years investing to first build out international footprints and then to respond to the growth opportunities in North American shale development

• Pressure pumping horsepower also had to be built to meet rising demand levels and higher service intensity

• We are watching oilfield service providers substantially reduce capex in 2019 from between 10-30% YoY and we applaud the companies proactively making cuts and increasing asset utilization levels. Investors have welcomed these strategic shifts

HAL’s Capex ($B) Trending Lower As Well

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SLB’s Declining Capex Levels ($B)


Find Ways To Drive Differentiation

• In OFS, companies should either compete to be the best or compete to be unique. In an industry that has recently become unattractive from an investor standpoint, firms should strive to establish a strategic position that is defensible long-term

• Operational effectiveness is not a strategy. Efficiencies result in lower costs, greater margins, and higher returns but can easily be competed away. It’s time for companies to do things differently and deliver true value to customers and investors

• One company that exhibits these tenets (and has the valuation premium to prove it) is Core Laboratories

• The solution is clear: If a company is not earning above its cost of capital over the long-term, it’s time to re-evaluate its strategy and/or to get out of the business completely

CLB’s Capex Intensity Relative to the Sector Core Labs’ Share Price and its ROIC

dear oilfield: time to delivery returns

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